Question

conditions, whether the issuer's assumption, which it had also issuer's industry and the general deterioration in economic used in prior years, that certain inventory required to review Excluded from its impairment testing a significant portion of for impairment was still applicable in the year under at selected inventory items for testing from those for which the the inventory that may have been impaired, because the Firm Failed to evaluate the reasonableness of certain of the signifi value estimates of inventory and investments in joint ventut cant assumptions that the issuer used in determining the fair tions that the Firm used when developing an independent est Failed to obtain support for certain of the significant assut mate of the fair value of one category of inventory; and Failed to test items in a significant category of inventory, which consisted of all items with book values per item below a Firm-specified amount that was over 70 percent of the The Firm failed to perform adequate audit procedures to evaluate the issuer's assertion that losses related to the issuer's guarantees What is the auditor's responsibility to consider information outside of the client's records and processing to develop suff- (the primary assets to re-evaluate, issuer already had recorded impairment charges; O . to inventory that had already been assessed as impaired by Firm's planning materiality. of certain joint venture obligations were not probable, because the Firm's procedures were limited to inquiry of management cient and appropriate audit evidence? b. Why did the PCAOB consider the identified items as critical mistakes in performing an audit? What is the critical error of omission by the audit firm? Why would the specific problem lead to a deficiency in sufficient appropriate evidence? c. Why is inquiry of management not considered sufficient evi- dence by itself? d. Assumptions are assumptions! What is the auditor's responsi- bility regarding the questioning of the assumptions used by the client? Keep in mind that the client will claim that assumptions are just assumptions; it is difficult to say that one assumption is more correct than another assumption. e. What do the deficiencies identified by the PCAOB suggest about the level of professional skepticism on the audit engage ments? What might be reasons for decreased professional skepticism? f. How could a standardized audit program lead to some of the problems identified earlier, such as failing to test a category inventory that had book value in excess of 70% of the firm's planning materiality, or limiting the testing of impairment management?

Answer 1

a.         The auditor is required by professional standards to not only consider information outside of the client’s records, but to actively solicit such information to evaluate for consistency with the client’s record-keeping, and to provide additional input on critical evaluation decisions the auditor must address.

b.         Inventory: There is a significant downturn in the industry. Presumably that downturn affects the saleability and therefore the valuation of the inventory. Recall that inventory always should be valued at the lower of cost or market, thus the auditor must consider current market conditions.

Inventory Sample Selection: If the client has already impaired part of the inventory, it does not make any sense to test it further for impairment (potential understatement of inventory). As noted throughout the text, the auditor is primarily concerned with the overstatement of inventory. Thus, the auditor should have tested the inventory that had not been examined for potential impairment.

Reasonableness of Assumptions. Increasingly, the financial statements are based on important assumptions about asset realization. The auditor needs to evaluate those assumptions in light of current economic situations.

Failure to Test a Significant Category of Inventory. The inventory category was 70% of materiality. The auditor needs to consider all aspects of inventory in determining whether inventory might be misstated. Remember, that testing of most accounts, including inventory, is based on samples; the auditor does not test 100% of most items. Thus, if there are significant problems in the inventory not tested, it could, when aggregated with other inventory categories, represent a material amount of misstatement.

Reliance on Management Inquiry related to the Joint Venture. The auditor should have:

• Read and understood the contract related to the joint venture.
• Determined the client’s obligations,
• Evaluate the success of the JV to date in order to determine whether a liability might exist.

c.         Inquiry of management cannot be considered sufficient evidence by itself because management is biased. The auditor should corroborate management’s assessment and analysis with independent evidence.

d.         Assumptions are assumptions! Yes, this is a common statement made by clients. But, both accounting and auditing standards require that the assumptions be reasonable, and based on current economic conditions, the client’s current financial status, and reasonable plans put forth by the client. There is a reasonableness criteria for all assumptions. For example, it is reasonable for an auditor to question a client’s assumption that it will earn 12% per year over the next 20 years on its investments in its pension obligation portfolio when most pension funds are earning 6% or less over a long period of time.

e.         The deficiencies identified by the PCAOB are evidence of a lack of professional skepticism by the auditor. While it is not always easy to state that there is one cause for the decrease in skepticism, the need to control audit costs could certainly have been a factor. Another factor might be related to the culmination of the auditor’s experience where most of the items identified do not lead to material misstatements. But, recall, audit risk has to be attained on all audits, not just on average.

f.          A standardized audit program is a guide that should be adjusted when conditions dictate that there should be adjustments. The danger that most audit firms have is that too many ‘standardized’ audit programs are approached rotely by the auditor, and the thinking that should take place on the audit is not present.